Motley Fool Hidden Gems Investing - 2 High-Growth Companies to Watch

Episode Date: May 6, 2023

Just because a stock is down 50% doesn’t mean that the business is broken. (Or does it?) Ricky Mulvey caught up with Motley Fool Senior Analyst Yasser El-Shimy to talk about some higher growth companies whose stocks have taken a hit. They discuss:  - How investors can approach growth stocks with a venture capital lens. - Profitability questions for a streaming data company. - A second look at a space company that went public via SPAC. Companies discussed: CFLT, LMT, SPCE, RKLB Host: Ricky Mulvey Guest: Yasser El-Shimy Engineer: Tim Sparks Production Assist: Alex Friedman Learn more about your ad choices. Visit megaphone.fm/adchoices

So, you're going to have your ups and downs in the short and medium terms, thanks to interest rates, thanks to fiscal policies, thanks to a lot of different factors, macroeconomic factors, recessions, and so on. But guess what? As Peter Lynch once said, we have had historically 13 recessions, and we've had 13 recoveries out of those recessions. I'm Mary Long, and that's Motley Fool Senior Analyst Yasser El-Shimi. If a growth stock gets cut in half, is it on sale?

or just less expensive. Ricky Mulvey caught up with Yasser to discuss the macro landscape for high growth companies, a mission critical software company now trading at half its IPO price, and a rocket maker with galactic ambitions. When others get fearful, it's time to do something. I forget the rest of the quote. Anyway, joining us now to talk about some strong, growthy companies in a down cycle is Motley Fool senior analyst Yasser El-Shimi. Thanks for joining us on this journey. Hi, Ricky. Good to be here. When I think about investing in super growthy companies, I almost think of it as a venture capital approach. Would you agree with that? Yes. Our Motley Fool co-founder and chief

rule breaker, David Garner, has, in fact, almost coined that term of a VC approach towards public investing. In that approach, you look for young, innovative, relatively small companies with massive runways for future growth, great products, invested leadership, and ideally a purposeful mission. And, you know, ideally also you want to have your portfolio reflect your best vision for the future. And that's kind of like, even when you see in the VC world where a lot of investors tend to back companies that they feel strongly about, you may want to also do that with your own personal investment portfolio. And one thing we have to keep in mind also with the kind of VC style of investing is that VC investors tend to hold their investments over very long periods of

time and even tend to upsize their stakes on those companies that show themselves to be resilient and successful. So as David Gardner would say, you should add to your winners, water your flowers, and trim your weeds. I'd also say that the VCs tend to have a couple of big winners that make up for, in a lot of cases, a majority of losses. When it comes to my style of investing, I like to have a mix of things. Do you go for this high growth approach for all of your stocks? No, I don't. And you're absolutely right, by the way, that, you know, only a few of the companies that you'd invest in using that VC kind of approach would work out. And, you know, most of the companies that you'd invest in may

not generate the kind of returns you were hoping for. However, over a very long period of time, those companies, those investments that do work out and those companies that do perform are going to generate hopefully the kind of returns that should more than make up for any losses you have incurred holding those, let's call them weeds for now. But back to your bigger question, which is kind of investing strategy here. I would say that the rule breaker style of investing or the high growth style of investing that I follow does not represent the entirety of my portfolio. I tend to try and invest across many different strategies. As someone who thinks of investing in terms of decades as opposed to years, I do lean more towards a rule breaker

style of investing, because I know that I have the stomach to hold those companies over very long periods of time and stomach the volatility. But not everybody can do that, obviously. It's a really hard thing to do. But even so, even if I can't stomach those kinds of churns, those kinds of gyrations and those stocks, I still like to hold companies that are more stable, more established. They own my fair share of what I consider to be balanced gross companies, small and mid-cap, profitable growth, even value sometimes. So I don't say that I'm an ideologue when it comes to investing philosophy. Being an ideologue and an investor seems to not work out for many of them.

Being a growth investor was much, much easier a couple of years ago. The aphorism, don't fight the Fed, is carrying out right now. As earlier this week, while the Fed signaled that it's going to pause its interest rate hikes, the risk-free rate of return right now is above 5%. percent, feel free to disagree. But I think this matters for growth investors because not caring about Fed actions was a lot easier a few years ago. And now, it would seem that growth investors have to pay a lot more attention to it. Yeah, you're definitely right. I mean, if you just take a look at Twitter, in bull markets,

everybody's a growth investor. In bear markets, everybody wants to park their cash in the bank, just get that interest or even go after dividend paying stocks. But here at The Fool, we are fundamental bottoms up investors. We love to look at companies and we think that fundamental company performance is the main determinant of returns over time. So you're going to have your ups and downs in the short and medium terms, thanks to interest rates, thanks to fiscal policies, thanks to a lot of different factors, macroeconomic factors, recessions and so on. But guess what? As Peter Lynch once said, we have had historically 13 recessions and we've had 13 recoveries out of those recessions. And if you zoom out and do not get consumed by the

headlines of the day, you're likely to do well over time as long as, of course, you put all of your energy and focus into selecting companies that you fundamentally believe in, that you think can outperform the market and make money over time. So let's dive into some of those growthy companies that have been hit, not just Carvana. One of them that you brought to the table is Confluent, ticker CFLT. This is one that has been cut in half since its IPO, despite a bump on surprising earnings. This is a tricky company to describe, even from watching YouTube videos and tutorials about it. So to set the table, what does this company do?

Yeah, you wouldn't be the only one to have difficulty to kind of fully understand what they do. So think of the movie, everything, everywhere, all at once. Before Confluent, companies used to collect data, store it either in data center or on premise or in the cloud, and then analyze it and act on it. So Confluent founders, they thought that system was inefficient, slow and full of blind spots. And so they invented Apache Kafka, which is an open source data streaming platform that lets you move and process data in real time. Now, as soon as data is received from the source, it is immediately transmitted across the entire tech stack of the business, analyzed by all applications and software programs and acted upon again in real time. Now, Confluent as a company was built to fully maintain, manage, and improve on Apache with what they called Confluent Kafka. So let me give this analogy, and maybe this is one that only train enthusiasts can fully appreciate, but I'll make it anyway.

If Apache was a train cart that moved products from point A to point B, Confluent is a whole rail network with autonomously driven trains that takes stuff everywhere all the time. Now, companies, of course, have the option to use the open source Apache Kafka version, but they will unfortunately need to maintain or dedicate many members of their IT team to operate and sustain that program. And that takes them away from doing the kind of work that can actually be valuable to the company's core product or value added. So the ROI for many companies using Confluent Kafka is significant as it cuts down on these operating expenses by a large margin. So I know the train analogy, the train network, the train cars, data in motion. I'll pretend that

I got it, but what's a real life example where one might see Confluent's technology in action? So, you know, actually, chances are you have used the technology, even though you may not have actually realized you're using the Kafka technology. But, you know, one good example of that is Instacart. A service like Instacart needs to have real-time visibility and instantaneous analysis of everything that's happening all the time. Where the shoppers are at all times, what products are they collecting, what products are missing, and therefore they need to suggest replacements for, and give customers a time estimate for the order arrival and so on. That's just one example. Another example is if someone uses your debit card in an unusual location for an unusual purchase or withdrawal, the transaction can immediately be flagged as fraudulent. The bank puts a hold on the card.

It notifies you. All of this happening instantaneously and across the board. Another example could be a stock exchange where millions of buy and sell orders are constantly flowing through and you need to execute on those in the most efficient and transparent manner possible. And so we will find like a stock exchange like Euronext, for example, in Europe, deploys the confluent Kafka technology. So I could go on, but Kafka is essentially what enables a lot of this real time action. And it quickly becomes mission critical, not just a nice-to-have software. It's when you don't have time to go back and forth from database to action with whatever that action might be in a stock exchange, inventory at a grocery store for Instacart,

or debit cards when someone's using it in an unfamiliar place. I want to talk about the financials a little bit with Confluent because it has high inside ownership. That's good. It's a sticky product. That's mission critical. That's good, but it also loses gobs and gobs of cash. In its latest quarter, its operating loss about equaled its total revenue. And this seems to be a habit of having a massive operating loss. Maybe it's because Confluent gives out a lot of free software. What's it need to do to be profitable? Well, you're absolutely right. They have been burning through a lot of cash, but it's important to put things in context. First, I would say that Confluent is still a

relatively young company, less than 10 years old. And even within those nine years of existence that they've been at, not even fully nine yet. But even during those years, they've started out with a Confluent program, which is an on-premise offering. And they've moved from that to Confluent Cloud, which is a hybrid or cloud-first offering that any company can use. And so they're still kind of still on the part of introducing the market to what this product is and the full capability of how this product can be used to transform the business and give good returns on investment. So, you know, understandably, they have prioritized growth over profitability in this young age. Now, secondly, the company has shown it understands that, you know,

the 0% interest rates, you know, are not coming back anytime soon. And the time has come to prioritize self-funding. And so they've guided towards reaching adjusted EBITDA profitability this year and positive free cash flow next year, all while growing sales by nearly 30% year over year. They have been also rationalizing their workforce, optimizing their sales, focusing on high return projects. And some of their expenses have been going towards going to prospective clients, demonstrating what Confluent can do for their business and signing them up. That is still important, but not maybe top of the list anymore. And maybe some of the existing big clients can provide higher profitability for Confluent,

and that's what they're going to prioritize. I got two pushbacks for you. From the latest call, CEO Jay Kreps said, The Confluent has less than five Kafka engineers on call for tens of thousands of production in Kafka clusters. That gives us a cost structure for operation that we believe is a thousand times better than our customers. end quote. So it seems like they're being efficient on labor costs from the call.

But I haven't seen that reflected in the company's operating margins. And also, while the company is young, it's already had a huge adoption cycle. More than half of Fortune 500 companies use Confluent software as of 2021. So that's one reason or two reasons, I should say, I remain a little skeptical and hesitant. So let me start with the last part of your question first about the use, the wide adoption of Kafka. Now, it's important to actually kind of make clear that when we say that 75% of Fortune 500 companies use Kafka, they're in fact using Apache Kafka, which is the free version, the free open source version of the software. So this in fact gives Confluent an opportunity to sell them on its flagship product and move them into that

self-managed or fully automated, I would say, data streaming platform that Confluent offers. Now, they actually estimate their total addressable market at $60 billion, whereas, in fact, their trailing 12-month sales came at just over $600 million. So, a lot of green grass left. Now, going to your first question about their operating expenses, I would say that That's not managing the data streaming platform has not been where Confluence expenses have gone. They've gone mostly towards building servers, for example, which is part of the value proposition that they are offering to their prospective customers. When you go to a modern enterprise that has potentially hundreds of different servers with dozens of tech staff, IT staff, who is literally manning the data streaming platform, the Apache Kafka, the open source version, and you're telling them, you don't need to worry about any of this. you don't need the servers, you don't need, you know, most of the IT people to dedicate all of

their time and energy towards, you know, managing this platform. We will do all of this for you from the backend. So the value proposition here is very clear to prospective customers that the total cost of ownership here, the return on investment from migrating towards the confluence product, the fully automated managed product is going to actually save them a lot of time and a lot of money. So that to me is definitely one of the strong points that Confluent has. Let's move to a bleeding edge tech company or more bleeding edge, which is Rocket Lab USA. This launches satellites and is working on a neutron rocket. It is a space startup that went public via SPAC. Unfortunately, that gives me vibes and memories of Virgin Galactic.

What does this company do? What's the case for Rocket Lab? Oh, boy, you don't want to be in the same sentence as Virgin Galactic if you're a space company. I personally have never understood the case for space tourism. I mean, who would spend hundreds of thousands of dollars to fly just to the edge of the Earth and come back down in a few minutes? But I'm probably not the targeted audience here.

Yeah, so Rocket Lab is not one of those companies. Yes, it came public via SPAC, and that will forever tarnish any company that ever did So after the painful experience of 2021, 2022, but, you know, I think there is something here. This is a company that is focused squarely in the commercial government and research space use cases. It has a long and flawless record of successful rocket launches, has plenty of serious customers, including NASA, the U.S. Space Force, and many universities and communication companies across the world. So, you know, why do I think it's a good investment? And, well, you know, the company is fast becoming another top dog with SpaceX and the commercial space industry. Launching rockets carrying satellites and returning them successfully is not easy as it sounds.

It is literally rocket science. We have had and we have seen so many failed launches by so many new entrants and newcomers into this space, including the likes of Relativity Space, Firefly, Astrospace, and I could go on. Even SpaceX, they just had a field launch with their Starship a couple of weeks ago. So Rocket Lab can, in fact, be proud of its pristine launch record here. Second, I would say that we actually have a global shortage, anticipated global shortage of launch capacity in the coming years. We may currently have over 100,000 licenses obtained to launch satellites into space, but nowhere near enough capacity to get them there. And that is even if we assume the likes of Blue Origin and United Launch Alliance will be successful to get their rockets off the ground and back safely. So, you know, you know, finally, you know, just looking even at the numbers, I could tell you that the consensus analyst estimates on S&P Cap IQ are for sales to quadruple over the next five years and for Rocket Lab to become profitable in two years.

I can also tell you that when I build my model, lower assumptions than those analysts have, I find the shares to offer plenty of upside opportunity. And just one thing I keenly look for in rule breaker type high growth investments is that I want to find them at a valuation that is reasonable against expected future earnings. And at less than 10 times 2026 EBIT multiples for such a high growth on a young company with clear competitive advantages, sounds good to me as a patient long-term investor. So much has to go right, of course, for these earnings to flow through and for this investment to be successful. And that's why, you know, trust in management, product and business strategy becomes key. But of course, things could go wrong, like with many of these kinds of companies. Yeah, I'm really knocking on wood after you said flawless launch record. And to clear something up, EV to EBIT basically means the enterprise value of the company,

how much it's worth compared to the company's earnings before interest and taxes. Startups are great, but it seems like size matters in this case. Can Rocket Lab reasonably compete against the aforementioned SpaceX, against Boeing, which builds jet engines as well? Yeah. Well, size does matter, but not in the way you think. This field has been dominated by very large rockets carrying very large payloads. SpaceX is the top dog here, no question about it.

Rocket Lab, however, has carved a niche of launching reusable small rockets because they cost less to launch and are faster to schedule for takeoff. The Electron has a sticker, which is made by Rocket Lab, has a sticker price of $7.5 million compared to SpaceX's Falcon 9, which will cost you $60 million. That's a big difference. Also, Rocket Lab, unlike SpaceX, is a one-stop shop for most space needs, including satellite building, components, software, operations command center, radios and solar panel systems, etc., etc. And this is why we have seen defense companies like Lockheed Martin placing orders with Rocket Lab for these kinds of systems.

You know, in defense, the ability to launch quickly is critical, and Rocket Lab can offer that thanks to its three launch pads, including in New Zealand, where there are fewer airspace restrictions on launches than here in the U.S., and because they're working towards refurbishing their rockets and launching them pretty quickly soon after. Finally, Rocket Lab is working on Neutron, which is a larger rocket capable of carrying up to 13,000 kilogram payload into the lower Earth orbit, 2,000 kilograms to the moon or 1,500 kilograms to Mars and Venus. It should also be capable of human spaceflight, but the primary goal of this one is to compete with SpaceX on launching heavy, very heavy satellites and mega constellations of satellites. One potential yellow flag about Rocket Lab that our colleague Alex Friedman brought up is that it has some pretty poor reviews on Glassdoor. I think just 50% of the employee base would recommend working there to a friend. Is that a yellow flag for you? So, yes and no. I mean, it definitely gives me pause. When I look at Glassdoor for ratings, I do obviously want to see the higher ratings, more positive ratings for the CEO, for the company culture, and so on. But it's not the complete picture. You know, again, if we take a step back here, we have a managed management team that hails from a fairly impressive group of companies and organizations, including General Dynamics, NASA, SpaceX, Broadcom, Aerojet, Rocketdyne, among others. We also have very strong ownership by CEO and founder Peter Baker owns around 11 and a half percent of the company.

And even more confusingly, when you look at other company review websites, including in this case, Comparably, for example, they have much higher scores. So they give a CEO rating of 90 out of 100 and, you know, executive rating of 75 out of 100. So it's kind of a mixed picture, I would say, where it comes to these websites can never really tell how accurate they are, what methodology they're using. And therefore, I just want to kind of like follow closely and see what's going on there and if there's anything to that. But ultimately, you know, if you are working in the space industry, if you're in the business of making rockets, you're probably overworked. You're probably working long hours, very high chances of failure, very cutting edge research projects you're working on. So I can imagine it be a stressful environment. Yeah, a lot of a lot of the complaints are about overwork, work life balance, that kind of thing.

I'm not trying to sound cold or dismissive, but I don't see how a space company is run without just an absolute maniac in charge. And I'm not accusing Peter Beck of being a maniac, but... I think he will wear that badge with honor. Fair enough. Let's do a quick check on the numbers before we wrap up. Rocket Lab is unprofitable on an operating business and launching rockets sure sounds expensive.

You mentioned that they can reuse some engines, but is that enough of a story for this company to scale into profitability? Yeah. So just to be clear, they have not started reusing their engines just yet. They have run tests to check whether they can. And so far, they report that they have been able to get their engines to work after they have landed back on Earth. But yeah, see, I think you raise a very important point here, which is kind of the profitability

or lag they're off for this business on an operating basis. Again, like I was saying with Confluent earlier, this is a relatively young company, still a long path of growth ahead. And for this business to generate a lot of operating profits, it's going to have to first launch more rockets more frequently, reuse the missiles, including the engines, become a vendor of choice for most space needs. And more importantly, it's going to need for the neutron rocket to actually work. one of the worst things that could possibly happen for this company and for this as an investment idea is for the Neutron to fail. If that was to happen, that's going to be a serious blow to this company's balance sheet and future prospects. Now, zooming out beyond the operating expenses, we should see CapEx peaking this year as a lot of the spending on

new manufacturing facilities, new launch pads, and the Neutron program kind of is undertaken can, and we get towards the end of that. Final question, Yasser, what's it going to take to convince you to ride on a neutron rocket? I don't think you can pay me enough. Yasser Alshami, appreciate your insight and for telling us about these companies. Thank you. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy stocks based solely on what you hear.

I'm Mary Long. Thanks for listening, and we'll see you tomorrow.